A credit agreement defines "Consolidated EBITDA" as net income plus interest, taxes, depreciation and amortization, then adds or subtracts a list of specific items: non-cash charges, transaction costs, one-time and restructuring charges, projected cost savings, and the earnings of businesses bought or sold during the period. Most of the discretionary add-backs are capped or time-limited. Every financial covenant, and often the pricing grid and the permitted baskets, is tested on this defined term. The adjusted EBITDA an owner presents to raise the loan counts only as far as the definition lets it.
- Where it lives
- Section 1 of the credit agreement: "Definitions"
- Starts from
- Consolidated net income of the borrower and its subsidiaries
- Uncapped add-backs
- Interest, taxes, depreciation, amortization, most non-cash charges
- Capped add-backs
- One-time and restructuring costs, projected cost savings and synergies
- Also governs
- Leverage and coverage covenants, pricing grids, baskets sized to EBITDA
Two EBITDAs
When a business raises debt, its owner or adviser presents an adjusted EBITDA: reported earnings plus add-backs for owner's personal expenses, one-time costs and the like. Lenders underwrite from that number after testing it, often with a quality of earnings report behind it. But once the loan closes, the adjusted figure is retired. Every covenant from then on is measured on the EBITDA the credit agreement defines.
The two are built for different purposes. The adjusted figure argues what the business earns. The defined figure is a formula the lender and borrower will both apply to future financial statements, quarter after quarter, without having to agree again. So the definition is narrower: it lists exactly which items may be added back, often caps them, and leaves out anything not on the list.
If an add-back is not in the definition, it does not exist for covenant purposes, however well it was documented at underwriting.
The definition, clause by clause
Definitions vary in length from a paragraph to several pages, but most lower-middle-market agreements follow the same sequence. The table walks through it.
| Clause | What it does | Common limit | What to check |
|---|---|---|---|
| Consolidated net income | The starting point: net income of the borrower and its subsidiaries | Excludes income of entities not consolidated, except cash actually received | Which subsidiaries count; income of any excluded ones |
| Plus interest expense | Adds back all interest, including fees and discount amortization | Rarely limited | That hedge costs and financing fees are included |
| Plus taxes | Adds back income, franchise and similar taxes | Rarely limited | Tax distributions for pass-through owners are handled elsewhere |
| Plus depreciation and amortization | Adds back non-cash charges for assets | Rarely limited | Amortization of intangibles from an acquisition is included |
| Plus other non-cash charges | Impairments, non-cash compensation, unrealized losses | Excludes charges that will require cash later | Reserves and accruals that are really future cash costs |
| Plus transaction costs | Fees and expenses of the financing and of permitted acquisitions | Sometimes capped or limited to a period after closing | Whether costs of deals that do not close qualify |
| Plus unusual, one-time and restructuring charges | Severance, relocation, litigation settlements, integration costs | Usually capped as a share of EBITDA, often with the cost savings below | The cap, and whether it is a single combined basket |
| Plus projected cost savings and synergies | Savings expected from actions taken or planned | Capped, must be identifiable and certified, and realized within a set period | The look-forward window and the cap |
| Plus sponsor management fees | Fees paid to an owner's management company | Only to the extent the agreement permits paying them | Whether payments are subordinated |
| Less non-cash and unusual gains | Removes gains on asset sales, debt forgiveness, one-time income | Not limited | That the list mirrors the add-backs |
| Pro forma adjustment | Includes a business bought during the period as if owned all year; removes one sold | Target earnings usually need financial statements or diligence | How the target's figures are evidenced |
The caps are where negotiation happens. A cap on one-time charges and projected savings, usually expressed as a share of EBITDA and often combined into a single basket, is the lender's protection against a borrower that discovers a new "one-time" cost every quarter. The look-forward window on cost savings, the period in which the savings must actually show up, stops a borrower from counting savings indefinitely.
A worked example: marketed versus covenant EBITDA
A buyer acquires a distribution business. The lender package shows adjusted EBITDA of 3,000: reported EBITDA of 2,300, after the buyer's market salary, plus a one-time legal settlement of 150, severance from closing a branch of 100, and projected savings of 450 from moving to a cheaper freight contract that has been negotiated but not yet started. The loan is 7,500.
The credit agreement allows one-time charges and projected cost savings together, capped at a stated share of EBITDA. In this example the cap allows 250.
| Marketed | Covenant | |
|---|---|---|
| Reported EBITDA | 2,300 | 2,300 |
| Legal settlement | 150 | Counted within the cap |
| Branch severance | 100 | Counted within the cap |
| Projected freight savings | 450 | Counted within the cap |
| Total add-backs | 700 | 250 (capped) |
| EBITDA | 3,000 | 2,550 |
| Leverage on a loan of 7,500 | 2.5 times | about 2.94 times |
If the leverage covenant is set at 3.0 times, the business closes with almost no headroom on the defined figure, though the marketed figure suggested half a turn. Over the next year the picture changes as facts arrive: the freight savings, once they start, flow into reported EBITDA and no longer need the basket; the legal settlement drops out of the trailing twelve months. But the first quarters, when the business is least known, are exactly when the cap bites. That is a reason to negotiate the cap against the actual add-backs before signing, and to size the covenant against covenant EBITDA rather than the marketed figure. See covenant headroom.
The quarters before closing
Covenants are usually tested on trailing twelve months, and in the first year some of those months come from before the loan, often before the buyer owned the business. Agreements deal with this in one of two ways. Some state a fixed EBITDA figure for each pre-closing quarter, agreed at closing from the quality of earnings work, so those quarters are not recomputed later. Others apply the definition to the seller's historical statements, in which case the seller's add-backs, such as family members on payroll and personal expenses, must be allowed by the definition or they are lost.
A stated figure is almost always better for the borrower, because it locks in the diligence result. Ask for it. For more on how periods are measured, see LTM and TTM; for how lenders credit earnings a business has only recently reached, see lending on run-rate EBITDA.
Acquisitions during the loan
For a business that grows by buying others, the pro forma clause may matter more than any add-back. It lets the borrower include a target's trailing earnings for the full test period, as if it had been owned from the start, while its purchase debt is also counted. Without it, leverage would spike after every acquisition because the new debt would be measured against only a few months of the target's earnings.
Lenders commonly allow the adjustment for permitted acquisitions, require the target's figures to be supported by financial statements or diligence, and sometimes allow projected synergies from the acquisition within the same cap as other cost savings. See pro forma EBITDA and financing add-on acquisitions.
Other clauses that change the number
- Frozen accounting rules. Many agreements measure EBITDA under the accounting rules in force at signing, so a later change, such as how leases are booked, does not move covenants. Check whether yours does.
- Restricted and unrestricted subsidiaries. Earnings of a subsidiary outside the borrowing group count only as cash it actually sends up.
- Other definitions that borrow it. The pricing grid and restricted payments baskets sized to EBITDA key off the same defined term, and the excess cash flow sweep both starts from it and steps down on a leverage ratio built on it, so a narrow definition costs you in several places at once.
- Equity cures. Where the agreement allows an equity cure, the cash contributed is often deemed to increase EBITDA for the test, but only for covenant purposes and only a limited number of times.
Transparent's financing model shows the covenant figure beside the marketed one, clause by clause, so the gap is visible before a term sheet is signed rather than at the first compliance test. See how we underwrite.
Common questions
- Is covenant EBITDA the same as adjusted EBITDA?
- No. Adjusted EBITDA is the owner's or adviser's presentation of what the business earns. Covenant EBITDA is the defined term in the credit agreement, with its own list of add-backs and caps, and it is what covenants are tested on.
- Can I add back owner's personal expenses after closing?
- Usually there is nothing to add back: if the new owner stops the expense, it disappears from the books. Where an agreement tests pre-closing quarters on the seller's statements, those add-backs count only if the definition allows them or the quarters use a stated EBITDA.
- What is a cap on add-backs?
- A limit, usually expressed as a share of EBITDA, on how much one-time charges and projected cost savings can add to the defined figure. It stops a borrower from lifting covenant EBITDA with open-ended adjustments.
- Do projected synergies count?
- Often, within limits. Agreements commonly require the savings to be identifiable, certified by an officer and expected within a set period, and count them within the same cap as one-time charges.
- Where in the agreement is EBITDA defined?
- In the definitions section at the front, usually as "Consolidated EBITDA". Read it alongside the definitions of consolidated net income, indebtedness and the covenant ratios, which depend on it.